Investing for short-term risk of deflation

BOSTON (MarketWatch) — It’s getting harder and harder to read the tea leaves. On Monday morning, pundits were suggesting that deflation, not inflation, was the bigger theme for this year and that you might want to invest accordingly.

Demand for banks loans by businesses both large and small, they said, was falling during the first nine months of 2011. And that suggested the possibility of deflation rearing its ugly head.

By Monday afternoon, however, the Federal Reserve said banks experienced, on net, somewhat stronger demand for loans by businesses in the final three months of 2011, and all bets on deflation were seemingly off.

Seventeen of 56 banks reported moderately or substantially stronger demand among companies with $50 million in annual sales or more, according to the Senior Loan Officer Opinion Survey on Bank Lending Practices. And six reported moderately weaker demand. Meanwhile, demand among small businesses for loans increased 26.4% from the previous quarter.

Given that change in demand for banks loans by businesses experts are now saying that the long-term risk of deflation is minimal, but the short-term risk is not.

For instance, John Largent, a CFA charterholder and chief investment strategist for Members Trust Company, said in an interview that the long-term risk of deflation is less than 50%, but short-term risk of deflation is higher because of the “deleveraging” cycle that is ongoing.

Jeff Witt, a CFA charterholder and director of research at Private Asset Management, isn’t forecasting deflation either, but he did say “the risk of deflation is still greater than we would like.”

And Doug Muenzenmay, a CFA charterholder with Medley & Brown and an adjunct professor at Mississippi College, is in the same camp: “We’re not investing our client’s assets with the idea that there is a large risk of deflation, but you can’t completely dismiss it.”

Near term, Witt said the risk of deflation would likely be the result of external factors, such as a “disorderly resolution” to the European debt crisis. “Should this occur, we would expect to see financial institutions curtail lending activity and corporations to further hoard cash,” he said. “Both of these activities would slow the U.S. economy and have the potential to result in a deflationary environment.”

And should that happen, the dollar would also likely appreciate relative to other currencies, given its safe-haven status, he said. And that would put downward pressure on import prices.

According to Witt, most investors are keenly aware of the risk of inflation, a dollar in the future buys less than is does today. But they are not as aware of deflationary risk. “I have heard people ask ‘Why is deflation a problem, would it mean that a dollar buys more in the future?’”

His reaction: “I believe that it is important to note that debt, which we all have too much of, becomes harder to service in a deflationary environment,” he said. “Traditionally, inflation makes debt easier to service over time.”

What’s more, Witt said capital expenditures are harder to evaluate or justify if prices are going down. “Both of these have the potential to slow the economy and lead to a negative feedback loop,” he said. “Deflation leads to slower growth, which leads to further deflation.”

To be sure, Federal Reserve Chairman Ben Bernanke is “keenly aware of these risks and we believe will do everything in the Fed’s power to avoid such an environment,” said Witt.

In such an environment, debt becomes more attractive to investors, Witt said. But it also becomes harder to service for borrowers.

High-quality bonds

So, if deflation does indeed rear its ugly head, Witt recommends increasing exposure to fixed-income investments, in particular investment-grade securities. He would avoid, however, Treasury Inflation Protected Securities and other variable-rate debt.

Largent said investors who fear the possibility of deflation might want to consider buying high-quality, long-term bonds with minimal default risk, such as U.S. Treasuries. “With deflation, whatever return you get will be real instead of nominal,” Largent said. “If you have deflation, inflation is zero. You get the real rate of return.”

Muenzenmay, however, said investing long-term, high-quality bonds right now comes with a good deal of risk. “The first thing you hear when the ‘d’ word comes up is quality,” he said. “Buy high-quality bonds. The problem that you have today is that is the asset class everyone has been buying for the past four years, so you look into U.S. Treasury or high grade corporate bonds and there is no yield to be found.”

He said the five-year U.S. Treasury note now trades with a yield of 0.73% and the 10-year U.S. Treasury bond trades at a yield of 1.83%. “The spreads are slim and none for high quality corporates,” he said. “If we do have a serious bout of deflation, these will end up being a good investment, even at these levels, but the risk/reward looks awful perilous.”

Indeed, Largent suggested that you will pay a dear price for betting wrongly on deflation. For instance, the price of long-term bonds will fall drastically should long-term rates rise above 2%. “You have an asymmetrical risk on long-term Given that, Largent recommends that investors perform what he calls a “shock analysis” to one’s portfolio before tweaking it for the risk of deflation. Examine, he said, what would happen to the value of long-term Treasury holdings if interest rates rise or fall by 1 percentage point or 2 percentage points or 3 percentage points, for instance.

High-quality stocks

Largent also said high-quality stocks would do well in a moderate deflationary environment. The reason: “The earnings per share will be more robust because there won’t be an inflationary component of it,” he said. “If you have a deflationary environment, you may have a P/E expansion in the market. Earnings per share will have more value because it won’t be deflated by inflation.”

And Witt said “dividend-paying equities become more attractive in a deflationary environment since the dividend income stream is no longer being discounted by inflation. “Within equities, we would look for companies that have a history of paying and increasing their dividend and who have pricing power,” Witt said. “The latter is important to evaluate to insure that the deflationary environment will not inhibit the company’s ability to maintain and/or increase their dividends going forward.”

For his part, Muenzenmay favors stocks in general, whether we experience a deflationary environment or not. He said bargains are to found in health care, technology, telecom and some areas of the consumer space.

Preferred, utilities and precious metals

In a deflationary environment, Muenzenmay said, “preferred securities may also provide reasonable returns in a deflationary environment, although you need to be aware of the underlying exposure to financials.” In addition, he said “utility stocks would typically do well, but they have enjoyed a nice run and appear fully valued for the ones that would weather a downturn anyway. “

And lastly, Muenzenmay — though he’s not recommending these assets for his clients — said “hard assets, including precious metals would likely outperform if the response to deflation continued to be met with each country’s version of qualitative easing as attempts at inflating continued to depreciate currencies.”

What to avoid

If deflation surfaces there are investments to avoid as well according to Alan Tu, a CFA charterholder with Ananda Capital Management. “Broadly speaking, I might consider avoiding leveraged assets as credit obligations become more burdensome in real terms during deflation,” he said. “Besides the financial and real estate sector, consumer discretionary businesses where customers use leverage to buy products, autos for example, may also be negatively impacted.”

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